Canadian Credit Health Update

2013 Q3

Introduction

These Canadian Credit Health Updates
are released every quarter. In these reports, I apply the same
analysis techniques that I used when watching the American financial
system through 2005-2009. These metrics should show early warning
signs of impending bank losses or even a banking crisis, just as they
did in the USA. All data comes from public financial reports.

There are significant changes to this
report's structure starting in 2013. I have re-examined metrics for
solvency and risk, leading to more meaningful numbers and better
comparisons in the tables. National Bank of Canada is now also
included.

Summary
for 2013 Q3

Big Five bank balance sheet
health is stable/improving

Canadian bankruptcies are
still very low, but we're currently seeing the greatest increase
since 2009 Q3

Canadian banks have $20
trillion of notional derivatives, up +7.4% from a year ago

This is a tremendous 1 year
growth in derivatives. The OTC growth is particularly worrying, up
$2.3 trillion or +13.8%

With their high leverage and
derivative exposure, banks could suffer large losses from market
shocks, despite healthy loan books

Notes on capital levels and leverage

The Big Five have slightly stronger capital levels this quarter (less leverage)

Changes in Methodology

Starting in 2013, the value used
for bank capital will now be Common Equity Tier 1 (CET1) capital
from Basel III guidelines. This is a new, stricter definition of
bank capital that is very similar to “tangible equity”
or “tangible common equity” (TCE). I believe this is
the best standardized value to use for bank capital, especially
under stress. I am using the
all-in number.

Leverage is now calculated
differently: Assets divided by CET1 capital. For example
leverage of 33:1 means that a bank has 33 times as much assets
as core equity capital. The new measure, a
straightforward ratio, is more intuitive and far less
susceptible to manipulation
by banks. The Canadian banks report regulatory capital
ratios based on risk-weighted assets (RWA), which some experts
believe is virtually meaningless due to all the flexibility in
determining RWA. I believe my measure is better and more
meaningful, and regulators are expected to introduce something
similar in 2019. The FDIC's Thomas Hoenig endorses a measure
that is nearly the same as mine.

My comments on bank capitalization
are based on the (very conservative) CET1 capital number and
non-risk-weighted assets.

Big Six Banks: Balance Sheet Health

Definitions:
GIL
= Gross Impaired Loans, CET1 = Common Equity Tier 1

Table A. GIL / Gross loans (higher = worse loan book)

This
is arough
measure
of how bad the loan book is, looking at impaired (non-performing)
loans. Before 2008, these values were under 1%^. Presently, the
values are quite low but this is a bit artificial: banks exclude some
US packaged loans/debt securities, and those non-performing amounts
aren't included. New accounting standards^ have also made these
numbers look better.

Similar
to the Texas
Ratio, a measure of bad loans versus the bank's capital. Around
the 100% mark, a bank's capital cushion is no longer adequate to
absorb loan losses. This ratio is believed to be an early warning
signal for bank failures, though the ratio has to get quite high
before solvency is threatened.

Bank

2013.Q3

2013.Q2

2013.Q1

RBC

7.1%

7.7%

7.6%

National

7.2%

TD

10.5%

10.3%

10.3%

BMO

12.8%

14.1%

14.6%

CIBC

13.0%

13.8%

14.5%

Scotiabank

14.6%

15.1%

15.8%

Average

10.9%

Avg Big Five

11.6%

12.2%

12.6%

Table C. Leverage multiple (higher = more leverage = more risk)

Higher
leverage means a bank is more susceptible to sudden shocks, and is
less capable of handling losses. High leverage means a bank has less
capital; conversely, low leverage means a bank has more capital.
Leverage = Assets / CET1 capital (see
technical details) and is sometimes stated as N:1
or Nx
leverage.

Bank

2013.Q3

2013.Q2

2013.Q1

BMO

26.6

27.5

27.3

RBC

29.3

30.7

29.8

Scotiabank

29.5

31.4

32.0

CIBC

31.8

32.4

32.5

TD

32.9

33.5

33.7

National

35.8

Average

31.0

Avg Big Five

30.0

31.1

31.1

Off Balance Sheet Derivative
Exposures

Amounts
are in trillions of dollars. All amounts are notional, which is the
face value of a contract (the amount of underlying money represented
by a contract). These are not prices or market values of contracts.
In other words, $1 trillion of notional exposure does not mean the
bank could lose $1 trillion; however, it shows the magnitude of
derivative contracts. For instance, RBC most certainly has a larger
derivatives book than any other bank and likely faces more
derivatives risk than others.

OTC
exposures are included here because I believe OTC contracts are the
most dangerous since they are illiquid, difficult to value, and
become worthless if the counterparty (another bank) collapses.

This
derivative exposure is hidden off-balance sheet where it can't
distress investors and depositors. The standard excuse given by banks
is that they are long some derivatives, and short others – and
the two (thanks to financial engineering) perfectly balance out risk,
resulting in minimal net exposure. But in reality, banks can only
maintain such perfect hedging during exceptionally low volatility. A
spike in volatility, or a counterparty failure, can suddenly create
enormous derivative book losses. This happened in 2007-2009 (wiping
out several banks), and will probably happen again. More derivative
exposure means more risk.

Bankruptcy Statistics

These
numbers show total Canadian bankruptcies (consumer + business).
Bankruptcy rates closely relate to bank loan quality and losses. Note
however that banks with significant US/international operations have
further credit exposure beyond Canada, which isn't reflected in this
graph.

The
volatile monthly data is smoothed using a trailing 6 month average
(moving average).

Bankruptcy
rates have been declining since 2010. However, the trend is currently
rising. This is now the largest increase since 2009 Q3 and must be
closely monitored to see if bankruptcy rates have reached a
multi-year turning point. I believe it's too early to tell.